FxWirePro: Hedging perspectives in G7 FX space during pre and post-central banks’ actions

From a vol perspective however, there is little value in positioning for this constructive baseline with implied vols only a whisker away from 2Q’17 cycle lows and investors already more than well-positioned for the same judging from our EM client survey and feedback from IMF/WB meetings.

The dollar revival that has been in train since late September gathered pace this week as the Euro sold-off sharply following a dovish ECB. The USD TWI has now gained close to 5% from its YTD lows, but that has oddly not impacted vol or risk-reversal pricing to any significant degree so far outside of select EM pockets experiencing idiosyncratic turbulence.

Indeed, VXY is almost a full vol lower since the dollar rally began, in part due to the passage of the event-laden few weeks in September (ECB, Fed, debt-ceiling), partly because of the day-weight impact of the quiet December holiday period, but most importantly because USD put demand from leveraged investors – particularly vs. EUR and EUR-correlates that had driven the Q3 vol uptick –has now ebbed.

More surprisingly, the shakeout in heavy short dollar positions has not really spiraled realized vols higher along familiar de-leveraging lines: chart 1 shows that the implied –realized vol gap for the VXY basket has remained a steady 0.5 –1.0 vol all year, and actual delta-hedged returns from a VXY-weighted basket of 3M straddles have continued to edge lower despite dollar strength.

We had advocated lightening up on risk last month by overwriting USD puts on cash USD shorts and in the process taking advantage of über tight risk-reversals that had compressed to multiyear lows during this year’s dollar decline.

Not only does that still remain a valid recommendation in our mind, but also there is a case for upsizing hedge ratios, albeit in selective, carry-sensitive fashion after events this week.

First, there is the risk of markets extrapolating from selloffs in EUR and CAD – the two currencies that had been at the vanguard of re-rating of non-US interest rate expectations – to the wider FX universe to justify an extension of dollar strength.

GBP, for instance, is a prime candidate for a dovish re-pricing after this week’s BoE’s hike that was already 90% priced for what could turn out to be a dovish hike.

Second, there are non-negligible odds of a more volatile extension of Treasury yields higher in coming weeks following the breach of the critical 2.40 level on 10s, which by anecdotal accounts had represented the upper-end of swaption dealers’ long gamma strike zone from programmatic vol supply in previous weeks; the cap on yields enforced by market makers’ delta-hedging behavior presumably stands to loosen as rates catapult beyond that strike concentration area.